Suppose someone offers you the following gamble: You pay $7 and toss a coin. If

Question

Suppose someone offers you the following gamble: You pay $7 and toss a coin. If the coin comes up heads, he pays you $10, and if tails comes up, he pays you $5. You in turn get the idea of offering another person a coin toss in which he pays you $7 and tosses another coin. You tell him that if heads comes up, you will pay him $9, and if tails comes up, you will pay him $5. You think you see an opportunity to earn an arbitrage profit by engaging in both transactions at the same time. Why is this not an arbitrage opportunity? How could you make it one assuming that you could get two people to engage in these gambles?

Explanation / Answer

Arbitrage is the technique of earning profit from price differential fo two variables from two different markets or locations as the case may be.

But in this case, there is equal probability of earning profit and loss. Hence, it is not an arbitrage opportunity.

There must be sure shot profit to be an arbitrage opportunity.

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